Burning the Furniture to Heat the House

Editor’s Note: When I started out as a stockbroker 40 years ago, my manager offered me this advice: “Your clients won’t remember all the times you made them money, but they will remember the one time you lost them money for the rest of their lives.”

Despite the profound changes to the global financial system that have taken place since then, that sentiment is as true today as it was then. That’s why I put as much effort into evaluating downside risk as I do to calculating upside potential. Focusing on one while ignoring the other is a recipe for failure.

That's also why I occasionally share questions posed by my readers that encapsulate that philosophy. A few days ago, one of them asked: “Do you have an opinion on JEPI? They pay great dividends, and I am considering purchasing them.”

I responded to that question on the Personal Finance website, but I felt it was important enough of a topic to share with everyone. I suspect a lot of investors are contemplating similar investments now and I want to be sure they understand the risks.

Underappreciated

Five years ago, the onset of the coronavirus pandemic sent the stock market into a tailspin. In just six weeks, the S&P 500 Index fell 40% before leveling off.

Fortunately, the fiscal and monetary policies enacted by Congress and the Federal Reserve quickly stabilized the economy. Six months later, the index was back above its pre-pandemic high.

Despite that poor start, the S&P 500 Index is up roughly 80% over the past five years. Over the same span, the JPMorgan Equity Premium Income ETF (JEPI) has appreciated less than 20% as shown in the chart below.

All that gain was achieved in the immediate aftermath of the pandemic. After peaking near $63 in December 2021, JEPI reversed direction and has never been that high since.

Swapping Income for Growth

It may surprise you to learn that JEPI’s top holdings include some of the best performing stocks over the past five years. That list includes NVIDIA (NSDQ: NVDA), which is up nearly 2,000 percent over that span.

In fact, JEPI’s investment strategy relies on owning stocks that are perceived as conferring above average growth potential. For that reason, the fund can sell covered call options against those positions for relatively high premiums.

Those premiums are passed on to the fund’s shareholder in the form of dividends. In short, JEPI is selling most of its holdings' long-term capital appreciation potential in exchange for immediate income.

At the start of this week while JEPI was trading around $59, its forward annual dividend yield equated to 7.3%. That is far higher than the 4.3% yield available on the 5-year Treasury Note the same day.

Fire Hazard

However, there is a very big difference between owning JEPI versus owning a bond. If you own the Treasury Note, you know in five years you will get all your principal back.

Not so with JEPI. In fact, getting all your money back in five years is about the best you can do. That’s because the call options sold to generate dividend income are essentially transferring most of the upside potential of the underlying stocks to someone else.

That type of tradeoff is sometimes referred to as “burning the furniture to heat the house.” The house remains standing, but there's nowhere to sit. In this case, selling the capital appreciation potential to someone else is like putting a torch to your living room furniture.

Sometimes, it makes sense to burn the furniture to avoid freezing to death. But other than that, you’d be better off finding something else to chuck in the fireplace to stay warm.

Do it Yourself

When the stock market is rising, the hidden risk to JEPI’s strategy is difficult for income investors to see. Since they prioritize cash flow over appreciation, they’re fine with static growth as long as those big monthly dividend checks keep rolling in.

However, a steep and sudden downturn in the stock market can reveal the true cost of JEPI’s strategy. The covered call options sold after its holdings have taken a big hit lock in those losses for a long time.

That risk can be avoided by creating your own covered call writing portfolio. You can mimic JEPI’s strategy, but you can also elect not to write covered calls after a major stock market correction.

Instead, you can sell put options against those same stocks to generate income. And once the stock market recovers, you can resume writing covered call options. That way, you don't have to burn any furniture at all!